Tuesday, February 20, 2007

Weak oil theory

After months of shadowboxing with the fanciful spectacle promised by Peak Oil Theory -- conventional world reserves are running out and prices will soar -- now may be the time to move on to another, more realistic perspective. A number of analysts are gearing up for a major oil-price correction, one that could drive a barrel of crude back down to a level that better reflects oil's long-term price: US$30.

Yesterday Russia announced a reduction in its expected average price down to US$55. This is unlikely to be the last Russian reworking of its oil price outlook. For a variety of reasons, the world price of oil is heading lower. Whether it will hit US$30 would be guesswork, but the band of oil-price skeptics keeps growing.

Weak Oil Theory, to coin a concept, holds that the long-term price trend for commodities is generally down. The history of world oil prices over the last 60 years is mostly flat, averaging maybe US$20 a barrel in constant dollars, except when the world has been cast into military conflict. The real driver of rising oil prices is geopolitical mayhem brought on by war, terrorism and other horrors created by governments.

Left to market factors, the price of oil would tend to drift lower as new technology increases the supply, not just of oil itself but also the supply of energy that can be extracted from a barrel of oil. Today's oil refineries get many more Btus out of a unit of crude oil than they used to. At the same time, demand for oil per unit of economic output -- or oil intensity -- is falling as energy users constantly shift energy practices and technologies. Since 1970 alone, the oil intensity of OECD countries has dropped by 50%.

These are the real fundamentals that, unimpeded by government, would keep oil prices down. Most recent long-range economic forecasts have expected oil to hold somewhere around US$30 for decades to come. In a review of long term oil developments published in 2004, the OECD Economic Outlook set a baseline scenario that forecast oil at US$35 a barrel by 2035. The "worst case" scenario had oil at US$45 by 2035, with a blip to the plus-US$50 range in the event of a major supply disruption.

The rise of China and India as major consumers of oil would bring fresh pressure on prices over the shorter term, but the scale of world reserves and the prospect of technological change would normally force price stability over the longer term.

We return now to a problem noted here many times before. Oil at US$30 a barrel, while great for economic growth and living standards across the globe, looms as a crisis on the horizons of most governments and politicians. In one country after another, from the rich to the poor, from developed to developing, political forces look at the prospect of falling oil prices with trepidation, even horror.

Take Russia, where the Putin government has grown increasingly dependent on US$60 oil. Oil keeps the government flush with cash and gives President Vladimir Putin much of the political and economic backing he needs to hold on to power. A fiscal crisis brought on by a sharp decline in oil prices could upset Putin's grip.

Even developing countries, or at least their governments, collect windfalls from oil prices. A recent news report from India said the government benefits from rising oil prices and that if the price were to rise to US$80 a barrel, the national government's fiscal deficit would be eliminated. Lower oil prices would increase government deficits. Falling crude prices leads to lower government excise tax collections on oil products, lower royalties on Indian oil production and lower dividends and taxes from state-owned oil companies.

Developed-nation governments have similar interests. Ottawa and some provinces have vested interests in high oil prices for fiscal reasons. Ottawa, for example, recently announced new spending on green subsidies to the provinces, money seen as a tax transfer from high energy prices. Talk of green trust funds as federal policy are based on the idea that money can be collected from oil revenue to be used for climate change and other environmental purposes.

Many politicians and political advisors in the United States frequently tout the benefits of high oil prices. They serve to curb demand for oil and reduce the popularity of high-emission cars. If the price of oil were to drop down to US$40 or US$30 a barrel over the next year, many people would be wringing their hands, alarmed at the idea.

For many people, the peak oil scare of the last year or so could soon give way to the reality of Weak Oil Theory and oil prices that simply do not fit their objectives.

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